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How to Beat the S&P with Master Limited Partnerships

Before I moved to Texas -- now some 17 years ago -- I lived in a
very old house in Poughkeepsie, NY. There wasn't a weekend when I
wasn't repairing, maintaining or restoring something.

I would watch episodes of "This Old House" in attempt to learn
better ways to address my house's needs. But invariably, I would
end up being jealous of Norm Abram, the show's master carpenter.
Norm had more tools than a hardware store. I think they even
invented tools for Norm to use.

Norm was right. If you have the right tool, even the hardest job
becomes easy. And to some extent, income investing can be a hard
job -- especially when investing in a low-yield environment.

But fear not, income investors, there is a tool designed
specifically for you!

## In the past 10 years, the S&P 500 has returned an average
0.2% a year. However, what if I told you there is a class of income
investments that has returned an average of 10% annually during the
same time frame?

MLPs allow for "pass-through" income, meaning they are not subject
to corporate income taxes. This design allows more income to flow
directly to their investors, or "unit holders." So it should come
as no surprise that MLPs, on average,
yield
7.1%, while the S&P 500 is dishing out an average yield of just
a fraction of that amount.

Most MLPs operate the pipelines and infrastructure used to
transport and store petroleum and natural gas around the United
States. The oil and gas business can be volatile, especially for
exploration and production companies that collect revenues based on
fickle
commodity
prices. But most MLPs charge fees based on the volumes they
transport and store. Volumes are far more stable than commodity
prices. And that translates into stable income for investors.

For example, take a look at the MLP
Kinder Morgan Energy Partners (
KMP
)
. During the past four years, the monthly
spot price
of oil has been on a roller coaster -- rising to more than $130 per
barrel and falling to near $40 per barrel. Through it all, KMP kept
pumping out its quarterly distribution.

MLPs are a unique investment class. They can generate a type of
income called
unrelated business taxable income (UBTI)
. And that makes holding individual MLPs a little trickier
tax-wise. Because of the tax implications of UBTI, individual MLPs
aren't suitable for IRAs or other tax-deferred accounts. If your
retirement account earns more than $1,000 of this type of income,
it will be subject to taxation -- which opens up a whole can of
worms for you and your
IRA
company. As a result, you probably want to hold MLPs in a regular,
taxable brokerage account.

Historically, most MLP distributions are comprised of about 20%
net income
and 80% return of capital (which is really just an allowance for
depletion or
depreciation
). The income portion is generally taxed at your ordinary
income tax
rate.

You don't pay taxes on the return-of-capital portion until you sell
the security, making MLPs ideal for long-term investors.
Return-of-capital distributions lead to a reduction in your
cost basis
. If you pay $50 a share for an MLP, for example, and receive a $5
return-of-capital distribution this year, then the cost basis of
your
shares
declines to $45. If you sell the shares next year for $55 a share,
you will have to pay taxes on your $10 gain. Investors in
individual MLPs will get mailed a K-1 tax form each year that
specifies the tax treatment of the prior year's payout.

If you have your heart set on investing in MLPs but only have
investable money in a retirement or tax-deferred account, there are
a number of closed-end funds that primarily hold MLPs. These funds
do not pay UBTI, so investors do not have to worry about having an
unintended tax consequence in their retirement accounts.

Whether you own individual MLPs or an MLP fund that does the heavy
lifting for you, you can generally count on an above-average yield
and a dependable distribution.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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